The blog of the University of Edinburgh's PIR subject area

Bond market vigilantes don’t undermine the nationalist threat.

Views on the nationalist threat not to assume Scotland’s share of UK debt suggest it’s a threat a future independent Scottish government wouldn’t dare carry out.

David Cameron described the threat as ‘chilling’ and ‘crippling’ for Scotland; Gordon Brown claimed Scotland would be ‘an international outcast’, noting (wrongly) that even Zimbabwe paid its international debt; Danny Alexander predicts Wonga-like borrowing costs; more calmly but no less worryingly, former member of the Bank of England’s MPC DeAnne Julius predicted that Scotland, in such a situation, would ‘find itself in a budgetary straitjacket, forced to raise taxes or cut spending, because financial markets will shun its new debt issues’ (Financial Times, 5 September). Even Crawford Beveridge of the Scottish Government’s Council of Economic Advisers appears to have doubts on such a strategy.

Such concerns are overblown, for a number of reasons:
1. As widely noted, Scotland will not be, or regarded by financial markets as being, ‘in default’ or as having ‘reneged’ on debt, because there are no loans or securities for Scotland to default on. The UK Treasury has already confirmed that the rest of the UK will remain liable for UK government debt, or Gilts. The inter-governmental debt that would come into being if Scotland did agree to assume a share of the UK debt can only come about as a result of agreement between both sides. Credit rating agency Moody’s assessment of the likely creditworthiness of an independent Scotland makes no mention of risks associated with assuming none of the UK debt, in a report (1 May 2014) detailed enough to mention the ‘low-probability’ risk of Orkney and Shetland seceding from Scotland.
2. A refusal to enter into such an agreement may well be unwise for all sorts of reasons connected to the negotiations surrounding a break-up. However, they are highly unlikely to be seen as an indication of any substantial reduction in an independent Scotland’s ‘willingness to pay’ investors in any future Scottish government bond. It is now largely forgotten that in 1932 Britain (and France) defaulted on war-related debts to the United States. Despite the Great Depression, the reason was largely political. Britain could have paid, but chose not to because Germany had stopped paying reparations. Britain’s reputation with bond investors was unharmed.
3. Most importantly, ‘willingness to pay’ is not the only broad criteria investors use to assess sovereign creditworthiness. There is also ‘ability to pay’. There are certainly reasons why an acrimonious divorce could undermine Scotland’s ability to pay, as Moody’s notes. However, central to that ability to pay will be the size of Scottish government debt. There is a world of difference between a debt to GDP ratio of around 90% (the current UK level), or even lower estimates based on per capita or historic shares, and virtually no government debt. In such circumstances Scotland’s ability to pay would be very high. Financial market reaction to improved debt dynamics is why even governments that default – of which, to repeat, Scotland would not be one – can often return quickly to the markets, despite their impaired reputation (as in the case of Greece’s debt restructuring).

UK politicians should not rely on bond market vigilantes undermining the nationalist threat.